Suppose there are two firms in an industry with marginal abatement cost functions given by MAC(A)= 2400-4E(A) and MAC(B) = 1400-E(B), respectively, where E(i), for i= A,B, is tonnes of CO2 emissions per month. The environmental damages caused due to their operation can be described by the damage function MD=0.8E. The regulator wants to apply an environmental policy to control pollution. They can use either a transferable emission permit system or uniform emission standards.

(a) Derive algebraically and graphically the aggregate marginal abatement cost function and find the socially efficient level of emissions in the atmosphere. (12 points) (A) Policy 1: Consider the case of a transferable emission permits system. The regulator issues permits for a total emissions level equal to the socially efficient level of emissions. Each permit gives the holder the right to emit one tonne of emissions per month. Each of the two firms is awarded (i.e., free-of-charge) an equal number of permits. (b ) Find the price of the permits in the market and the optimal allocation of the permits. How many permits are traded in the market? Who is the buyer and who is the seller? (10 points) (c) Calculate the total compliance cost for each firm and the total social compliance cost at the optimal allocation of the permits. (9 points) (B) Policy 2: Consider the case of uniform emission standards. The regulator sets uniform emission standards to the two firms. (d) Calculate the total compliance cost for each firm and the total social compliance cost. (9 points) (C) Policy 1 vs. Policy 2: You should assist the regulator choose one of the two policies. (e) Which policy should the regulator choose? Why? Justify you answer based on the previously conducted analysis. (4 points)